Some thoughts on high-end home flipping

Have spoken with a bunch of people over the past few days who are involved in high-end home flipping.

This isn’t the kind of stuff that was going on in 2009-2012, where you could buy a foreclosed single family in say, Highland Park, for $400k, dump $50k into it, and sell for $550k.

Those deals are long gone.

What people are doing now is buying higher-end properties in the range of $1-2MM and then either tearing down and re-building or else doing a total re-model / expansion, and aiming to sell for $2-3MM.

There appear to be decent returns to this business. However, the risk is considerable, because:

  1. A lot of this stuff is going on, so the supply of homes in this price range is likely to expand rapidly; and
  2. In this price range, there is no way to get an acceptable rental yield if you are forced, for whatever reason, to hold the home

There’s one other reason I dislike this business: taxes. The IRS treats home flip profits as ordinary income. So your 20% return becomes 10% after tax. Not sure I love that risk-reward profile as an investor.

Do single family home rentals work in LA in 2015?

One of our clients asked an interesting question yesterday that I think worthy of some discussion here:

“Has Adaptive done any single family home deals where the rental numbers would work out to at least cover PITI after fixing up the property?”

In other words, can you buy a single family home as a rental and at least break-even?

The answer is “No”, and here’s why:

In LA, there is a massive single family home ownership premium. By this we mean: People are willing to pay prices for homes which result in monthly payments that are far in excess of what the property can generate in rent.

This is (somewhat) rational, because home prices have tended to rise faster than inflation, so there is a reward for speculating, which is being priced in.
Because of this effect, it is extraordinarily difficult to find a single family home rental deal that breaks even. At this stage of the cycle, the only areas where this might be possible would be areas which are really, really bad (eg where no one else wants to buy and so there is little / no home ownership premium).
Interesting side-note: In 2009-2011, when there were tons of foreclosures and not many buyers, the home ownership premium in many improving areas almost disappeared, allowing investors to buy and rent single family homes and get some kind of yield.

Whoa! Got my hands on someone else’s PPM…

Just got my hands on the marketing materials for a deal being syndicated by one of my (larger, more established) competitors.

Was obviously thrilled to take a look at the forecast economics and how they are structuring deals.

The structure is fine. They’re actually not really being compensated sufficiently for the work they’re doing on the deal.

But it’s not because they’re super generous.

It’s because the economics of the deal are, to be blunt, awful.

After doing a bunch of work to the units, the equity can expect a ~2-3% annual yield.

To clear the 8% pref they are offering, the sponsors depend on an exit at a 5% cap after 3-4 years.

But that assumes we’re still in a 0% interest rate environment. If rates rise during that period, cap rates will, too, and it might be pretty hard to sell a 5% cap.

And that’s not all. The worst part of the whole pitch is that they’re factoring in a 2.5% cost of sale. On our deals, we assume 7-8% (5% to the brokers, 2-3% for escrow, title, transfer tax, etc.).

Once you factor in a realistic cost of sale, the deal is actually pretty sour for everyone.

Sometimes I fall into the trap of thinking that people who have done this longer than me and are therefore larger know something I don’t. In this case, it seems they don’t.

What I did yesterday

From the “This Ain’t Just Capital Deployment” files:

What did you do at your job yesterday?

Me? Oh, I negotiated and then personally oversaw voluntary move-out by a guy who had been arrested for threatening his neighbors with an ax.

Of course, I brought along two armed guards, plus a crew to help move his stuff.

He turned out to be a pretty reasonable, decent guy.

He lived up to his word and I lived up to mine and I’d like to think we both came away from the deal happy.

You might ask why I did this, rather than having one of my employees do it:

  1. I’m not going to ask an employee to take on physical risk, particularly if I wouldn’t take it on. Sometimes being a leader means putting yourself out in front; and
  2. Getting this done was very important from a deal perspective. And we take that kind of thing EXTREMELY seriously… if we were going to fail at this, it was not going to be because I sent someone else.

 

A long term building program

 

Have been doing some thinking about ground up development of small-to-medium size apartment buildings lately.

We’ve not built ground-up before, but we’re getting closer and closer and I believe ground-up is likely to be a big part of our business mix in the coming years.

Here’s how I think about it: Assuming reasonable planning (eg the right product in the right neighborhood) and execution (eg not screwing up the construction), the returns are mostly dependent on the business cycle.

If you buy and build when times are bad, you’re likely to do quite well. And if you buy and build when times are good, you’re likely to do ok but not great.

But, if you take the long-term view that people will always want to live in LA and that it will always be hard to build here, you know that rents are likely to grow faster than inflation.

That means your margins are likely to improve over time. And that means that even OK deals will end up being pretty good ones over a sufficiently long time horizon.

So, I think there’s a strong argument for building a few buildings / year, pretty much every year (with the possible exception of the 1-2 years in each cycle where land prices are really, truly crazy). If you do this consistently for, say, 25 years, you will end up with something like 50 high-quality buildings in good locations.

Some deals will end up better than others, mostly due to extrinsic factors. But, viewed as a portfolio and managed appropriately, you’d have a cashflow monster which ought to spit out increasing amounts of free cash, even accounting for the occasional new roof, etc.